Markets @ Bidvest Bank - 14 July 2014

Fundamentals:

US:
• The White House has lowered its 2014 federal deficit once again to $583bn which is a drop of $66bn and will be welcome news as it further supports the argument that the US finds itself in a cyclical upswing. Still the debt pile is growing and there is a lot more work that needs to be done to get to grips with the rising debt pile. Nonetheless this will be seen as good news if the trend continues and a dip back below the 3.0% of GDP level is anticipated in 2015. This will cement the USs status as a hedge against risk.
• Citigroup is the latest US banking company that is due to announce a settlement with the state to end probes into the bank’s sales of mortgage-backed bonds.
UK:
• On Friday, the BoE proposed that the UK’s biggest banks set aside more capital than was planned under global rules that have been devised to prevent a repeat of the financial crisis. Specifically the BoE was referring to the holding of supplementary capital on top of the 3% minimum leverage ratio that regardless of the risk profile of the bank.
• Data released last week Friday shows that UK construction came under pressure in May dampening Q2 growth expectations. This raises serious questions about the sustainability of the current upswing given that some of the slowdown was related to private sector home building.
Asia:
• Final Japanese industrial production growth for May was upwardly revised to 1.0% y/y vs. a prior 0.8% y/y, nonetheless remaining at an August 2013 low to point to on-going sluggishness in the sector. In a separate release, the capacity utilization rate was seen contracting for the second month, however at a less pronounced rate of -0.7% vs. -2.2% in April.
• In regional elections on Sunday, PM Abe’s ruling Liberal Democratic Party took a surprise blow as the party failed to secure the open gov.’s seat in Shiga. Support to the leading party has been compromised following Abe’s controversial efforts to ease military rules. According to the most recent Yomiuri Shimbun poll conducted July 2-3, PM Abe’s support rate had dropped to 48% vs. levels in excess of 60% in January, while the opposition had risen to around 40% from 30% in January.
EU:
• Issues with BES in Portugal remained a focal point into the close of the week, however markets digested the localized nature of the problem and discounting systemic concerns for the periphery and broader EZ. The Portuguese sovereign has the cash reserves on hand to more than adequately cope with a potential bank solvency issue here, which the central bank there has denied is an issue in any case.
• Whilst now looking like a storm in the tea cup, last week’s events do underpin two factors: firstly, in the short-term, it highlights the extent of weak hands prevalent in current market conditions that can be flushed out quickly by turns in sentiment. Secondly, as we approach the ECB’s asset quality reviews in October, EZ banks will come under increasingly more scrutiny so the possibility of more volatility of this sort is prevalent.

Developments worth noting:
• Last week the markets were provided a reminder as to the sorts of debt issues still lingering in the EZ periphery as one catalyst that can generate broader market pressures. Investors have become heavily reinvested in the EZ periphery, particularly through the sovereign bond markets, since late 2012 and although the conditions that have supported this rally remain intact (global monetary policy accommodation, and now more than ever from the ECB) it does offer a warning signal on the broader theme of risk assets that are unable to indefinitely sustain their positive momentum and volatility that cannot remain indefinitely low. So it has been for some time now, the focus will remain with the major central banks and whether or not the data supports any form of liquidity tightening (read: lessening of the monetary glut) going forward.
• This leads us into the SARB rate announcement due to take place on Thu this week, a decision which holds increased importance in conditions where rand fragilities are still high and where some are questioning the bank’s inflation-targeting credibility as it responds to higher inflation in a very tepid and delayed manner. Bloomberg economist consensus also reveals more mixed expectations than usual where the median estimate of 5.63% represents a split in an unchanged decision relative to the expectations of a 25/50bp hike. The SARB would need to hike a bare minimum 25bp should it wish to meet market expectations and leave the rand marginally less exposed to what remains still worryingly large twin deficits.
• The data last week in the form of the May mining and manufacturing production figures if anything will indeed reinforce the SARB’s tendency towards doing the bare minimum, and much will come down to how it foresees the inflation risks looking further out than the latest 6.6% y/y print in May. The growth outlook remains undeniably weak but from an inflation perspective the rand on a trade-weighted basis has weakened 3.5% since the last MPC decision, inflation expectations have remained elevated and the 6.6% y/y CPI peak will have come much earlier than expected. It leads us to believe that a compromise may well need to be made so that the bank can show its intent on reducing inflation while still remaining accommodative of growth, which it could achieve through a 25bp hike while simultaneously talking down longer term rates.
Data/Events for the next week:
• SARB rate decision and policy statement on Thu the main attraction domestically this week. Consensus reveals mixed expectations with many believing the drag on growth will be sufficient to dissuade further hikes for now. We do however believe that the probability leans in favour of a 25bp hike as the extent of the inflation uptick together with more rand weakness cannot be ignored. Prior to the decision, May retail sales data will be of interest. The choppy and overall weak trend on retail sales is expected to hold as inflation and unemployment continues to drive household financial strain.
• Offshore, UK CPI and ILO unemployment data this week will be of importance as it offers further insight into the UK cyclical upswing and helps to shape what have been rising BoE rate expectations in recent months. US retail sales, industrial production and housing starts data also feature, with the market expecting broad improvement across these sectors.

Trade Weighted ZAR:

• The trade-weighted rand has lost its strengthening momentum that featured into the end of Jun, now sitting some 0.6% weaker month-to-date to take year-to-date depreciation back up to 2.0%. Part of the reason for the faltering momentum in the short term has been the concern attached to the Portuguese banking system as one of its largest banks missed a short-term debt payment, sparking speculation of potential contagion in what remains a heavily undercapitalised EZ banking sector. However, many believe it will be only a localised issue for now and under the conditions of still very accommodative ECB and other G4 central bank policy, it has not led to a very broad risk-off move.
• The second issue for the rand is that of the Numsa strike where the union has yet to accept increasing better wage offers from employers. It is a growth negative and leaves an element of uncertainty in place as many businesses have threatened to shut down and relocate to economies with friendlier labour markets, reflecting on a fragile investment climate. It also forms part of the broader theme of growth sluggishness which no doubt will be touched on by the SARB again in its policy statement this week.
• When considering the SARB policy decision, we believe that the bank is already behind the curve when it comes to setting policy appropriate for the prevailing inflation conditions and has left rates low so as to encourage consumption rather than long-term savings. Should the SARB to fail to meet market expectations of a hike and continue on its very shallow hike cycle, this will leave the rand exposed through this very low-to-negative real interest rate environment. This is but one aspect of the rand’s fragility alongside still high twin deficits and inadequate policy continues to speak towards a currency that will underperform in the medium to long term.

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